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Apple
What you Should Know About ESO Grants

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By RodgerRafter
December 31, 2001

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Employee stock options are one of the biggest factors affecting share price movements, but most investors are oblivious to their significance.

Here are the things every investor should know about employee stock options grants:

1. Short-term price movements.

Corporate executives have an uncanny ability to grant themselves options on the day a stock is hitting a low.

Steve's 20,000,000 share options grant was made on 1/12/00, at a strike price of $43.59. Had they been granted one week earlier they would have been priced at $52. One week later would have priced them at $53.28. Those options won't expire for another 8 years. They will be well in the money when Steve eventually gets around to exercising them. The timing of the grant will eventually mean an extra $180,000,000 worth of profit for Steve.

This year's options grants for the top executives came on 1/17/01 at $16.81. Besides being $1.77 better than the average employee grant, the timing of the grants was again remarkable. After the close that day, Apple reported earnings that missed estimates by 8 cents, but the stock rose by 21.9% over the next week. Fred's 1,000,000 share grant would have been worth $3.7 less if he had waited another week to price it.

The moral of the story: If Apple takes a sudden, unexpected drop in mid-January, assume that executive stock options are being priced and buy like crazy.

2. Mid-term price movements.

Individual stocks tend to oscillate between being overpriced and underpriced over a period of years. Wall Street makes money off of this phenomenon by hyping stocks at their highs and ignoring or downgrading them at their lows. Executives make money [off] the cycles by granting themselves large amounts of options at the lows and exercising and selling them at their highs. In this regard, both the analysts and the executives have an interest in seeing added market volatility, and they can work together at the expense of the ignorant masses of investors. You can expect earnings warnings, bad news & downgrades after a stock has already fallen. You can expect upgrades, good news and good reports after a stock has already risen.

Typically, the cycle goes like this:

a. Stock is ignored or suffering from bad news and downgrades. Meanwhile, discouraged shareholders are selling, market makers are accumulating, and executives are pricing their options.

b. The bad news continues, but the stock moves up while market makers accumulate.

c. The company generates nothing but good news, while executives exercise their shares and sell them to market makers.

d. Market makers begin pumping and dumping the shares on the general public, at ever increasing prices.

e. The stock starts to fall even though good news continues.

f. Bad news drives the stock down further and the cycle starts over.

The moral of the story: Buy profitable companies when the valuation is low and the news is bad. Sell when valuations are high and the news is all good.

3. Long-term valuation.

Understanding ESOs is important because they will dramatically effect how much a company will be worth down the road. Placing an accurate monetary value on stock options grants is a difficult task that involves estimating how much the stock will be worth when the options expire.

Options accounting principles allow companies to claim that options don't count as an expense and therefore don't affect earnings. This, of course, is absurd, but the principle exists for two important reasons. First, it allows companies to vastly overstate their profits, which in turn helps Wall Street dump overvalued stock on an unsuspecting public. Second, it allows executives to compensate themselves handsomely while most investors don't have a clue as to how they are being cheated.

ESOs serve to dilute the value of existing shares and reduce EPS numbers when they go in the money. Q4 diluted EPS was based on a share price of $15.51 on 9/29/2001. At that price, less than 6 million shares were included in the diluted totals. At apple's current price of about $22, about 50,000,000 more shares would need to be included in the diluted totals, reducing EPS totals by 1/7. When Apple eventually rises above $43.59, Steve's 20 million shares worth will also have to be added to the diluted totals and will further cut into EPS.

I own more than $100,000 worth of Apple, which I've been accumulated over the last 4 years. I expect it to appreciate at about 10% per year, and I expect to make another 20% per year off of the stock's volatility. I believe in the products and the business model and would expect the share price to appreciate much more rapidly, if not for the astounding number of stock options that Steve grants his employees every year.

By my estimate, Apple is worth about $22 right now. (For more on how I value Apple, read post #37730 from this message board.) In 10 years, at 10% growth per year, I expect Apple to be worth about $57. If you don't think it will be worth at least $57 in 10 years (and $52 in 9) you probably shouldn't view Apple as a good long-term investment at $22. Those shareholders that are bullish on the stock while downplaying the significance of ESOs are contradicting themselves out of ignorance and/or denial.

More options info: Most Apple employees receive new stock options every year, but have to continue working for 4 additional years for those options to vest fully. The options expire 10 years after they are granted. Therefore, to get the most value out of an options grant, the employee should continue working for Apple for at least 4 more years, and then avoid exercising the options (so that they can appreciate interest and tax free) until just before they expire.

Last year, Apple employees received 34.857 million shares worth of stock options. The average exercise price is $18.58, so if the stock is worth $52 when the options are exercised, Apple's current employees will be making up to $1.165 Billion off of this year's grants alone. Fortunately, many current employees will leave the company before their current options vest, and many others will exercise their options and sell their shares earlier than would be wise. The true cost to shareholders of this year's grants will probably only end up being about half a billion (still astronomical).

That figure only applies if AAPL appreciates at about 10% per year. If Apple does worse, then the cost of the options is less, and if Apple does better, than it will be significantly higher. Large amounts of stock options serve to create a huge drag on a company's ability to increase shareholder value at a rapid rate, but are insignificant to a company bound for bankruptcy.

Much is made of the claim that options give an employee incentive to work harder. But in truth the performance of the company is dependent on factors far outside the individual employee's control. What's left, instead, is yet another tool that enables the executive to run a company for his own benefit, rather than for the benefit of the shareholder.

The numbers are staggering, and it's probably easiest to just ignore them and think about other things. Nevertheless, the truth is out there. While most companies abuse their stock options at shareholder expense, Apple under Steve has been among the worst. Consider that there are now 97.179 million shares worth of options outstanding for Apple, vs. about 28 million when Steve took over. This translates to about 21.69% ownership in the company with another huge grant due in less than a month. I could list several other examples that demonstrate how Steve's loyalties are to those he works with, and not those he works for, but the above numbers should already prove the point. Until Shareholders rise up in protest, the stock option grants will only get larger.

Moral of the story: Companies typically are run for the benefit of executives, and not shareholders, because executives are the ones in control, and shareholders seldom are aware of what is going on.


Those who don't remember my posts of the past 4 years (here, on Raging Bull before that, and on Yahoo before that) may be confused by my bullishness on Apple contrasted with my criticism of Apple management and the stock market. I encourage you to go back and read my old posts. Hopefully you'll find something eye opening.

Rodg.

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